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Capital One Rolls With the Punches

Advanced statistical analysis is transforming Capital One into an international financial services powerhouse.

Just a few short years ago, Capital One Financial(NYSE:COF) was a small, fast-growing credit card company. Now it's a diversified financial services company offering everything from credit cards to auto loans to home loans.

From 1994 to 2003, the company was able to grow both earnings per share and total customers by a compounded annual rate of 28%. And from 2000 through 2003, Capital One's share of the U.S. credit card market grew from 3.3% to 7.2%. The question is, does Capital One have an earnings encore in the works?

What separates Capital One from its competitors is its information-based strategy ("IBS"). IBS combines one of the world's largest databases with an army of statisticians and financial analysts. Through the use of advanced statistics and rigorous testing, IBS allows Capital One to cherry-pick the most profitable customers and charge them based on their risk profile.

Room to grow?What is a highly fragmented market? The U.S. domestic auto loan market is an example. Is there a bank, credit union, or S&L that does not offer auto loans? GM(NYSE:GM), Ford(NYSE:F), Honda(NYSE:HMC), Toyota(NYSE:TM), etc., all offer auto financing too.

Capital One believes that its IBS system gives it a competitive advantage within fragmented market segments, where no single company controls more than 20% of the market. IBS is used to match customers to credit offerings based on their credit score, credit usage, and other variables. The system is composed of advanced scoring models, computer information systems, and well-trained personnel focused on identifying and developing products and services that address the demands of a changing marketplace.

With the average American's wallet overflowing with credit cards, and the record level of personal debt and bankruptcies, the U.S. credit card market does not offer the same level of opportunities for growth that it did in the recent past. In addition, the industry is highly competitive and in the process of consolidating.

Capital One will continue to grow, in part due to a smart expansion and acquisition plan put into place in the late 1990s. The company expanded credit card operations to Europe, Canada, and South Africa. It also entered the auto loan business by acquiring two automobile financing companies. And it bought Amerifee, a leading provider of patient financing for elective dental, orthodontic, vision, and cosmetic procedures. On January 11 of this year, Capital One increased its presence in the auto finance market by purchasing ONYX Acceptance. ONYX specializes in purchasing used car loans from auto dealers. These new markets should allow the management of Capital One to prove once and for all that IBS gives it a competitive advantage.

Capital One has a number of competitive advantages in the auto finance segment. First, its IBS system allows it to charge customers the appropriate interest rate given their risk characteristics. Second, its loan process takes place on the Internet, with none of the bricks-and-mortar legacy costs that many of its competitors have. At the moment, customers can choose Capital One for new and used car financing only if they purchase a vehicle from a dealer.

The chart below reflects the changes to Capital One Financial's loan portfolio as it branches out into other segments of the financial services market.

BusinessSegment

Percent ofTotal Loans12/31/96*

Percent ofTotal Loans12/31/00

Percent ofTotal Loans12/31/02

Percent ofTotal Loans12/31/03

Credit Cards

100%

78%

68%

63%

Auto Loans

0%

2%

13%

13%

International Operations

0%

20%

19%

24%

Total

100%

100%

100%

100%

* Data obtained from Capital One's annual and 10-K reports

Capital One's change of plansFair, Isaac(NYSE:FIC) created the FICO Scoring system, which is widely used by financing institutions to predict future payment risk. Customers with the highest credit risk are classified as "sub-prime," those with average credit risk are classified as "prime," and those with the lowest credit risk are classified as "super prime."

No doubt thanks to a poor economic outlook and the failure of a few sub-prime lenders, federal banking regulators issued new regulations regarding sub-prime lending institutions in January 2001. The guidelines gave them the right to require financial institutions to increase their reserves and capital base held against sub-prime assets.

Capital One had a large portfolio of sub-prime loans because it believed that, thanks to IBS, it could earn large margins in the sub-prime market without large corresponding losses. In 2002, federal regulators stepped in and required Capital One to double its reserve requirements for sub-prime loans. This obviated Capital One's chance to show that, unlike, say, Providian Financial(NYSE:PVN), it could successfully and profitably navigate the sub-prime market while the economy stinks. Because of this intervention, one cannot conclude with certainty that the IBS system would work effectively during periods of economic difficulty.

Thus, starting in 2002 the company changed gears and began focusing on prime and super-prime customers. The rationale for this change was simple: By doubling the reserve requirements for sub-prime loans while holding the reserve requirements for prime and super-prime customers steady, federal regulators changed the risk/reward profile. Capital One found it could grow at a faster rate by focusing on prime and super-prime customers.

A word of cautionCapital One funds much of its growth by pooling together many of the loans it originates and selling pieces of the resulting pool to outside investors. It uses the proceeds to make additional loans. These pool-buying outside investors require that Capital One retain an interest in the pools that it sells. That retained interest is considered an asset and placed on the balance sheet.

The process sounds simple, but in reality, it's highly complex and involves a great deal of uncertainty. The present value of the retained interest is determined by a complex formula, which takes into account several factors such as interest rates, default rates, and the estimated remaining life of the loan. A slight change to any of these variables will result in different valuation estimates and different income streams.

There is additional risk to using pooling to fund growth. Currently, the market for pooled loans is stable, but changes in the economic and regulatory climates could change that.

On March 7, Capital One announced plans to acquire Hibernia(NYSE:HIB), a regional bank with operations in Louisiana and Texas. In theory, Capital One could use Hibernia's low-risk deposits to fund much of its consumer loan growth and lower its reliance on using pooling to fund growth.

The company has proven that it can adapt to changing economic conditions, and, in my opinion, is a worthy consideration for your personal portfolio.